Small Business Blog

How to Calculate Financial Ratios for Your Small Business

What If I say; “go ahead and calculate your business’s key financial ratios for me would you”. Would you give me a 'blank look' and politely ask me to leave? Well, here's a secret, you don’t need to be a math whiz. All you need is your business’s financial statements and a calculator. What is missing for most small business owners is… i) an understanding of what the financial ratios are, ii) why you should calculate them, and iii) an example to work through. Hopefully we can cover off these 3 points in this article.

What is a Financial Ratio and Why Should YOU care?

A financial ratio is simply a numerical value which is determined through a calculation using numbers taken from your business’s financial statements (normally the Income Statement (Profit & Loss) and the Statement of Financial Position (Balance Sheet). It’s just a simple equation that gives you a number. Normally the number is expressed as a decimal (e.g. 0.20) or as a percentage (e.g. 20%).

So, what’s the big deal about getting a number? Well, in isolation a ratio (number) does not give you a lot of value, but if you compare your ratio (number) with another ratio (number) calculated using the same method you can start to see if your ratio (number) is higher or lower and whether that is a good or bad thing.

The other ratio (number) that you are comparing your ratio (number) with could be calculated either;

• using your business’s financials and just at the different time (hence you are looking to see if your business is trending up or down in this ratio, are you getting better or worse?)
• using another specific business’s financials (hence you are comparing your business against another business’s performance, are you better or worse?)
• using averages from your industry (hence you are comparing your business against the average performance or your industry, are you better or worse?)

By identifying a set of financial ratios that are important to your specific business, then regularly calculating them you can monitor your business performance. This will help you make decisions about what tactics should be implemented to get improvements for each area of monitored performance.

Once you implement the tactics you identifed as required for an improvement in a specific financial ratio, then after a some time, perhaps one month, or one quarter or one year, you can recalculate the ratio to see if your changes have been effective or not!

Let’s look at some example ratios.

Profitability Ratios:

Profitability ratios measure your business’ use of its assets to gain an acceptable rate of return.

• Gross Profit Margin = Gross Profit / Revenue
• Net Profit Margin = Net Profit / Revenue
• Return on Equity (ROE) = Net Profit / Average Shareholders Equity

Liquidity Ratios:

Liquidity ratios measure your business’s availability of cash to pay its debt.

• Working Capital =  Current Assets – Current Liabilities
• Current Ratio = Current Assets / Current Liabilities
• Coverage = Fixed Assets / Long Term Liabilities
• Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
• Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

Activity Ratios:

• Activity ratios measure your business’s effectiveness in the use of its resources.
• Inventory Turnover Rate = Cost of Good Sales / Average Inventory
• Inventory Days = 365 / Inventory Turnover Rate
• Accounts Receivable Turnover Rate = Annual Credit Sales Revenue / Average Accounts Receivable
• Average Days of Accounts Receivable Collection = 365 / Accounts Receivable Turnover Rate
• Days Sales Outstanding Ratio (DSO) = Accounts Receivable / (Annual Revenue / 365)

Debt Ratios:

• Debt Ratio = Total Liabilities / Total Assets
• Debt to Equity Ratio = (Long-term Debt + Value of Leases) / Average Shareholders Equity
• Debt Service Coverage Ratio = Net Operating Income / Total Debt Service

How to Calculate Financial Ratios Using Your Statement of Financial Position (Balance Sheet) & Income Statement (Profit & Loss):

Get a calculator and your financial statements. That’s all you need. Let’s look at the example…

Table 1:

Table 2:

Profitability Ratios:

• Gross Profit Margin = Gross Profit / Revenue = $400,000 / $1,000,000 = 0.4 = 40%
• Net Profit Margin = Net Profit / Revenue = $150,000 / $1,000,000 = 0.15 = 15%
• Return on Equity (ROE) = Net Profit / Average Shareholders Equity = $150,000 / (($50,000+$200,000)/2) = $150,000 / $125,000 = 0.75 = 75%

Liquidity Ratios:

• Working Capital =  Current Assets – Current Liabilities = $200,000 - $175,000 = $25,000
• Current Ratio = Current Assets / Current Liabilities = $200,000 / $175,000 = 1.14
• Coverage = Fixed Assets / Long Term Debt = $300,000 / $125,000 = 2.4
• Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities = $175,000 / $175,000 = 1
• Cash Ratio = (Cash + Marketable Securities) / Current Liabilities = $25,000 / $175,000 = 0.14

Activity Ratios:

• Inventory Turnover Rate = Cost of Good Sales / Average Inventory = $100,000 / $50,000 = 2
• Inventory Days = 365 / Inventory Turnover Rate = 365 / 2 = 182.5
• Accounts Receivable Turnover Rate = Annual Credit Sales Revenue / Average Accounts Receivable = $1,000,000 / $125,000 = 8
• Average Days of Accounts Receivable Collection = 365 / Accounts Receivable Turnover Rate = 365 / 8 = 45.6
• Days Sales Outstanding Ratio (DSO) = Accounts Receivable / (Annual Revenue / 365) = $125,000 / ($1,000,000 / 365) = 45.6

Debt Ratios:

• Debt Ratio = Total Liabilities / Total Assets = $300,000 / $500,000 = 0.6
• Debt to Equity Ratio = (Long-term Debt + Value of Leases) / Average Shareholders Equity = $125,000 / $200,000 = 0.625
• Debt Service Coverage Ratio = Net Operating Income / Total Debt Service = $150,000 / $125,000 = 1.2

How to do this regularly?

One of the easiest ways to be able to calculate your key financial ratios regularly is to have them self calculate using a excel spreadsheet. So, all you need to do is once a month enter the data figures from your business’s financial statements into the excel spreadsheet calculator and you get your new ratio figures. We provide a simple excel based Financial Ratios Calculator for members of mimosaPLANET’s Online Small Business Coaching, Development & Improvement System.

Action Points

• Calculate YOUR business’s current ratios.
• Calculate YOUR business’s ratios from 3 months ago, or at the same time last year, or 1 month ago.
• Compare the 2 sets. Where are you improving? Where are you getting worse?
• What do you need to do to improve this for next month we you calculate these ratios once again.

Go for it, make it happen!